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LATIN AMERICAN CENTRAL BANK REFORM:
PROGRESS AND CHALLENGES
Mr. Carstens
Presented at the High-Level Regional Seminar on Inflation Targeting Hosted by the International Monetary Fund and Bank Al-Maghrib Rabat, Morocco─April 4, 2007
The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper.
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1
SECRETARÍA DE HACIENDA
Y CRÉDITO PÚBLICO
Latin American Central
Bank Reform: Progress and
Challenges
March 2007
2
Organization
I. Introduction
II. New Institutional Framework for Monetary Policy
III. Central Bank Independence (CBI) Index
IV. CBI and Macroeconomic Trends
V. Remaining Challenges
VI. Concluding Remarks
3
Introduction
In Latin America 1990 was characterized by
– unprecedented high inflation (500% on average)
– the end of a 10-year period of stagnation on per capita GDP (-0.1% on average).
Governments faced the need to tackle inflation and made structural changes aimed at laying the foundations for a rebound in economic growth.
Central bank reform became a key component of the new economic agenda in most Latin American countries.
The objective of the reform was to restore confidence in monetary policy to fight inflation.
4
In the 1990’s, the legislation governing Latin America’s central banks was reformed, based on four main pillars.
1. Defining a clear mandate for central banks’ to ensure price stability
2. Giving central banks political independence to design monetary policy
New Institutional Framework for Monetary Policy
Price stability plus other objectives, with no indication of priority Price stability as the sole or primary objective Operation of the payment
system Stability of the financial
system Growth or economic
development Argentina, Bolivia, Colombia, Costa Rica, Dominican Republic, Mexico, Peru, Venezuela
Chile, Honduras, Nicaragua Guatemala, Paraguay, Uruguay
Brazil
5
The reform was based on four main pillars…
3. Granting operational independence to perform monetary policy
Central banks have freedom to formulate and execute monetary policy.
They are severely restricted of financing public expenditure.
Operational independence is sometimes undermined as a result of central banks’ quasi-fiscal losses.
4. Making central banks accountable
Governors are required to appear before the legislature to report on the performance of the central bank.
Central banks publish its monetary program and inflation report.
New Institutional Framework for Monetary Policy
6
An Index of Central Bank Independence was estimated based on the provisions contained in the central bank legislation.
The index of CBI measures de jure, and not de facto,independence.
The index is built on five aspects of central bank independence, which are assigned different weights:
1. Political independence (20%).
2. Central bank’s mandate (15%).
3. Autonomy in the formulation of monetary policy (15%).
4. Restrictions in lending provisions to the government and to commercial banks, as well as financial independence (40%).
5. Accountability requirements (10%).
The resulting value of the CBI gives a score between zero and one.
Central Bank Independence Index
7
Latin American central banks are more independent today than they were in 1990. The degree of independence varies from one country to another.
After the reforms the average index of CBI increased from 0.427 to 0.774.
Countries that currently have a CBI Index of over 0.80: Peru, Chile, Colombia, Bolivia, Mexico and the Dominican Republic.
Countries that currently have a CBI Index in the range of 0.64 and 0.79: Argentina, Venezuela, Costa Rica, Nicaragua, Paraguay, Guatemala, Honduras, Uruguay and Brazil.
The difference between countries is found primarily in terms of political independence.
Central Bank Independence Index
8
Even though inflation has been reduced in most Latin American countries, there are still some macroeconomic challenges.
Legal Central Bank Independence and Macroeconomic Trends
Per capita real GDP growth(%,moving average t=10)
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
1989
1992
1995
1998
2001
2004
2007
Inflation(%,moving average t=10)
Fiscal Balance / GDP(%,moving average t=5)
0.0
100.0
200.0
300.0
400.0
500.0
600.0
1989
1992
1995
1998
2001
2004
2007
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1989
1992
1995
1998
2001
2004
2007
9
CBI is statistically significant in explaining inflation performance between 1990 and 2002 for the Latin American and Caribbean economies.
Legal Central Bank Independence and Macroeconomic Trends
CBI and Inflation in Latin America(Before and after the reform of central banks)
0
20
40
60
0.2 0.4 0.6 0.8 1
CBI
Aver
age
annu
al r
ate
of in
flatio
n
CBI and Fiscal Deficit in Latin America(Before and after the reform of central banks)
-12
-8
-4
0
40.2 0.4 0.6 0.8 1
CBI
NFP
S ba
lanc
e / G
DP
Source: Jácome and Vázquez (2005) and IMF, IFS.
Source: IMF, IFS and Western Hemisphere Department
10
The reform of central bank legislation in Latin America contributed to the change in the monetary policy regime and the operating framework observed in most countries.
Changes in the Policy Regime and Operating Framework of Monetary Policy
Most central banks increasingly migrated from exchange rate pegs towards exchange rate flexibility.
A number of central banks adopted an inflation targeting (IT) strategy as a way of anchoring inflation expectations.
Central banks modernized their operating framework for monetary policy, shifting from money base control to an alternative regime where the central bank uses a short-run interest rate as an operational variable.
11
Despite the successes in defeating inflation, central banks in Latin America still face important challenges.
Challenges facing Latin America’s Central Banks
1. Achieve price stability
2. Restore confidence in domestic currencies
3. The need to cope with capital inflows while maintaining
policy consistency
4. The perils of financial system weaknesses and the lack
of fiscal discipline
12
1. Achieve Price StabilityChallenges facing Latin America’s Central Banks
While inflation in Latin America has already declined to single digits, in most countries it has not converged yet to the world inflation.
Further reducing inflation will be increasingly difficult because of its potential adverse effects in output.
Central banks may face opposition to tight monetary policies.
012345678
<4% 4% - 8% 8% - 10% >10%Annual rate of inflation (period average)
Num
ber o
f cou
ntrie
s
BoliviaChile
El SalvadorPanamá
Perú
BrasilColombiaEcuadorMexico
GuatemalaHondurasNicaragua
ParaguayUruguay
ArgentinaCosta Rica
Dominican RepublicVenezuela
Average Inflation in Latin America(2002-2007)
13
40
60
80
100
Africa Asia andthe
Pacific
Europe MiddleEast andCentralAsia
LatinAmerica
Per
cent
age
of fu
lly +
bro
adly
obs
erve
d(F
rom
tota
l crit
eria
)
1. Achieve Price StabilityChallenges facing Latin America’s Central Banks
Implementing a more efficient monetary policy hinges not only oncentral banks’ ability to conduct monetary policy, but also on making central banks’ policy more transparent and predictable.
While central banks in the region have already enhanced accountability and transparency standards, there is still room for improvement.
Transparency of Monetary Policy(Latin America versus other regions)
14
1. Achieve Price StabilityChallenges facing Latin America’s Central Banks
The high rate of turnover of central bank governors in a number of Latin American countries suggests that monetary authorities remain vulnerable to political pressures an to periods of political instability.
Turnover rate of central bank governors
Bolivia
ChileColombia
Costa Rica
EcuadorEl Salvador
Guatemala Honduras
NicaraguaParaguay
UruguayVenezuela
ArgentinaBrazil
Mexico
Peru
Dominican R.
0.0 0.2 0.4 0.6 0.8 1.0 1.2Turnover Rate
15
2. Restore Confidence in Domestic CurrenciesChallenges facing Latin America’s Central Banks
Two groups of countries facing lack of confidence in national currencies:
a. Countries with pegged currencies to the US dollar. The use of an exchange rate anchor has helped to bring down inflation but this policy regime bears costs and vulnerabilities
o The lack of a rapid and low-cost exit strategy from the exchange rate peg.
o The limitation for conducting monetary policy, and hence developing the necessary skills and institutional credibility.
The central banks of this group need to assess whether it is wise to continue with the current monetary regime or to shift to an alternative scheme.
16
2. Restore Confidence in Domestic CurrenciesChallenges facing Latin America’s Central Banks
b. Countries that have not recovered their monetary independence following past episodes of high inflation and/or financial instability.
o The years of macroeconomic instability are still alive in the market participants' mind. As a result, distortions endure: a high level of financial dollarization and the “peso problem”.
BOLIVIA
0.6
0.7
0.8
0.9
1.0
1990 1993 1996 1999 2002 2005
Dol
lar d
epos
its
0
5
10
15
20
25
Infla
tion
rate
Dollar deposits / total depositsInflation
PERU
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1990 1993 1996 1999 2002 2005
Dol
lar d
epos
its
0
10
20
30
40
Infla
tion
rate
Dollar deposits / total depositsInflation
Financial Dollarization and InflationURUGUAY
0.6
0.7
0.8
0.9
1.0
1990 1993 1996 1999 2002 2005
Dol
lar d
epos
its
0
20
40
60
80
100
Infla
tion
rate
Dollar deposits / total depositsInflation
17
2. Restore Confidence in Domestic CurrenciesChallenges facing Latin America’s Central Banks
o Correcting these distortions will take a considerable length of time and will require the support of certain government policies.
o Central banks need to persevere in consolidating their reputation.
o Strengthening prudential regulations applicable to foreign exchange transactions is crucial to reestablish an independent monetary policy.
18
3. How to Cope with Capital Inflows While Maintaining Policy Consistency
Challenges facing Latin America’s Central Banks
If markets are unable to anticipate and understand the decisionsof central banks, and if central banks lack a consistent policy reaction function, monetary policy will be less effective.
Following the institutional reform of central banks, policy inconsistency decreased significantly.
Inconsistencies remained in a few central banks as a result of using the exchange rate as a nominal anchor.
The recent surge of capital inflows has put additional pressure on the consistency of monetary policy.
As capital inflows soared, domestic currencies tended to appreciate, leading central banks to the dilemma of whether or not to intervene in the exchange rate market to avoid real appreciation.
19
3. How to Cope with Capital Inflows While Maintaining Policy Consistency
Challenges facing Latin America’s Central Banks
Response to Capital InflowsSome Central Banks opted for intervention…
PERU
0
5
10
15
20
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1
Nom
inal
exc
hang
e ra
te
0
5
10
15
20
Inte
rest
rate
s
NXR
Interest rates
PERU
80
90
100
110
120
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1R
eal e
ffec
tive
exch
ange
ra
te
6,000
8,000
10,000
12,000
14,000
16,000
18,000
Mill
ons
of d
olla
rs
R EER
Internat io nal R eserves
COLOMBIA
1000
1500
2000
2500
3000
3500
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1
Inte
rest
rate
s
0
5
10
15
20
25
Nom
inal
exc
hang
e ra
te
N XR Interest rates
COLOMBIA
80
100
120
140
160
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1R
eal e
ffec
tive
exch
ange
ra
te
6,000
8,000
10,000
12,000
14,000
16,000
Mill
ons
of d
olla
rs
Internat io nal R eserves
R EER
20
3. How to Cope with Capital Inflows While Maintaining Policy Consistency
Challenges facing Latin America’s Central Banks
Response to Capital InflowsOthers opted for no intervention…
MEXICO
100110120130140150160
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1
2007
M1R
eal e
ffec
tive
exch
ange
ra
te
30,000
50,000
70,000
90,000
110,000
Mill
ons
of d
olla
rs
R EER
Internat io nal R eserves
MEXICO
89
1011
12131415
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1
Nom
inal
exc
hang
e ra
te
0
5
10
15
20
Inte
rest
rate
s
N XRInterest rates
BRAZIL
0
1
2
3
4
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1
Nom
inal
exc
hang
e ra
te
10
15
20
25
30
35
40
Inte
rest
rate
sN XR
Interest rates
BRAZIL
20
40
60
80
100
2000
M1
2001
M1
2002
M1
2003
M1
2004
M1
2005
M1
2006
M1
2007
M1Rea
l eff
ectiv
e ex
chan
ge
rate
30,000
60,000
90,000
120,000
Mill
ons
of d
olla
rsR EERInternat io nal R eserves
21
3. How to Cope with Capital Inflows While Maintaining Policy Consistency
Challenges facing Latin America’s Central Banks
Central banks’ intervention may be damaging from an institutional standpoint.
In the long-run, central banks may not be very effective in containing the real appreciation because the real exchange rate is an endogenous variable.
The appropriate way to mitigate the effects of the real appreciation is that tradable activities increase productivity.
22
4. The perils of financial system weaknesses and the lack of fiscal discipline
Challenges facing Latin America’s Central Banks
Most countries have made progress in establishing appropriate framework for preventing and managing banking crisis, but more needs to be done.
The new reforms must emphasize precautionary regulations.
The role of central banks in the prevention and management of banking crisis should be clearly established in law.
After fiscal consolidation during the early 1990s, fiscal deficits have soared again in a number of countries. A tight monetary policy combined with a loose fiscal stance produces an inconsistent policy mix.
23
4. The perils of financial system weaknesses and the lack of fiscal discipline
Challenges facing Latin America’s Central Banks
Effects of Banking Crisis on Growth and InflationARGENTINA
-15-10
-505
1015
1990
1993
1996
1999
2002
2005
Rea
l GD
P %
gro
wth
-20.00
-10.00
0.00
10.00
20.00
Infla
tion
Rat
e %
Growth Inflation
B anking C risis
ECUADOR
-8-6-4-202468
1990
1993
1996
1999
2002
2005
Rea
l GD
P gr
owth
%
-120
-70
-20
30
80
Infla
tion
Rat
e %
Growth Inflation
B anking C r isis
DOMINICAN REPUBLIC
-4-202468
1012
1990
1993
1996
1999
2002
2005
Rea
l GD
P %
Gro
wth
-20-100102030405060
Infla
tion
rate
%
Growth Inflation
B anking C risis
MEXICO
-8-6-4-202468
1990
1993
1996
1999
2002
2005
Rea
l GD
P gr
owth
%
-50
-30
-10
10
30
50
Infla
tion
rate
%
Growth Inflation
Banking Crisis
24
Concluding Remarks…
Under the new institutional framework, monetary policy has modernized and inflation has dropped to single-digit rates in a majority of countries of the region.
Today, central banks still need to address important challenges.
Central banks will not succeed in their endeavors unless government ensure macroeconomic stability and the viability of countries.
Governments should make sure that actions speak louder than words in supporting the autonomy of central banks, demanding in exchange rigorous accountability and transparency procedures from monetary policy.